I believe that having faith in ‘the law of averages’ can be deadly. A timeless piece of wisdom I learned was, “if you can’t swim, then never cross a river if it is on average 3 ft. deep.”

Meaning the river could be 1 ft. deep along the entirety of it – except in the middle, where it is suddenly 15 ft. deep…

Ah, the law of averages.

Knowing this wisdom – I will try to use the mistakes from trusting averages to my advantage. But, I recommend you read the books and works of Mark Spitznagel, Nassim Taleb, Nate Silver, and Benoit Mandelbrot. These men understand uncertainty and “tail” events in a unique way and how to position yourself.

I tried to make a simple Normal Distribution vs. Fat Tail Distribution graph to help explain this costly error that the “statistically” dependent make.

To put it lightly: I hunt for fat tails. I look for topics, mostly stocks or even sports betting, to use the crowd’s faith in the numbers against them.

But it isn’t easy. You have to have an independent, knowledgeable, reasonably realistic opinion, and a bit of luck that the market is not pricing in certain risks.

A couple examples I like to use is remember the holy-grail of pharma-stocks, Valeant (VRX)? How the seemingly unstoppable rising stock price collapsed90% within a couple of months – better known as “V-Day” for investors.

What about Enron? or even the entirety of 2008?

Outside of finance – remember when Ronda Rousey was knocked out cold by Holly Holm during UFC 193? It was an unthinkable event. Ronda was the undefeated champion. She was considered the greatest ever. And so on.

I gambled on that fight. The odds of Ronda winning were so high that I would have had to bet $500 to simply make $100 profit. I don’t know about you, but betting $500 to only make 1/5th of my money in profit with a 50/50 chance of being right or wrong, isn’t attractive.

But that is what the bookies offered…

It isn’t even about taking the underdog all the time. It’s about finding the asset that the market becomes emotional and complacent over. The market was so crazy about Ronda that no one cared to think, “what if she slips? Are we underestimating her opponent? What if Ronda is having a bad night? Has she lost her competitive advantage since now people study her fighting style?”

I asked these questions. I also thought that betting $100 to make $500 made much more sense.

I guess using the past averages of her wins and the crowds euphoria, betting on Ronda winning seemed like a sure thing. Even the independent thinker could have seen how the odds of Ronda winning were still fairly good.

But not that good to bet $500 for $100…

That is what “hunting for fat tails” is about. It isn’t really the event happening itself, but you’re betting against the sentiment of it. I didn’t bet against Ronda losing per se. I bet against the markets sentiment and the price it cost to i.e. the risk/reward.

For stocks I buy long dated out-of-the-money options on the assets that are priced for perfection. These are my way of betting.

Another example, look at Chipotle (CMG) recently.

Of course these types of sudden “tail” events don’t occur often. If they did the market would price it in. But it sure as hell happens more than the numbers tell us.

Usually the ones advocating that the risks of things not going right are higher than everyone assumes are laughed at.

That is, until it happens…

Today I am advocating going against the markets sentiment that volatility (VIXM) is dead and instead to go long volatility assets.

I don’t trust averages, but in the last year alone the VIX spiked over $15 on five different occasions. That is over 50% from current VIX prices today.

Is this as rare and un-probable as the market is making it out to be? I don’t think so.

And to our benefit, the longer the lowVol goes on, the higher the chance of volatility spiking occurs. That is, the more individuals feel that volatility is gone, the riskier they get, which naturally breeds higher volatility in the future.

I detail this in a previous article about the infamous “Minsky moment.”

I like to say that the lowVol times is the author of highVol times; and
vice versa…

When investors feel safe from turbulence, they make riskier decisions. It is like how wearing a helmet while bike riding can make you do things you wouldn’t do without a helmet on. Contrary to that, if investors fear turbulence and uncertainty, they become risk averse and freeze up and wait. Such is human nature.

One breeds the other: the risk aversion leads to quiet markets and only the least riskiest things survive, which eventually calms markets down. Once the calm and stability is reached, investors slowly move back into riskier assets. Rinse – wash – repeat.

And today I believe the VIX is horribly underestimating the future as well as gold (GLD) and the VanEck Junior Mining ETF (GDXJ). I am long both through out-of-money long dated call options and own put options on various other stocks, especially car related.

This week the Vix index, the most popular short-hand measure of expectations for near-term volatility for US stocks, has traded close to the lowest level since Bill Clinton was elected in 1993, prompting a further furrowing of brows from those exasperated at such apparently reckless levels of market relaxation – wrote the Financial Times.

Growth is weak. Inflation is softening. Retail sales and real incomes are weak. And yet the S&P500 (SPY) is trading at all time highs.

So who is chasing stocks higher in a time of such low volatility? It appears it is companies borrowing money to buy their own stock back…

The lack of volatility is something we have heard the Fed speak about over the last month. It is their fear that markets have become “complacent”.

Three weeks ago, the president of the San Francisco Fed said he was “somewhat concerned about the complacency in the market…there seems to be a priced-to-perfection attitude out there…” and “the stock market is very much running on fumes.” That same day, the vice chair of the Fed said, “We know that complacency must be avoided.” Last week, the president of the Kansas City Fed said the “combination of asset valuations…together with low levels of implied volatility in equity and bond markets, could be signaling broader complacency in financial markets.” – wrote Brian Reynolds, Canaccord Genuity analyst

They have flat out said it, and no one seemed to care. The Fed is worried that the markets are becoming calm in times where diligence is needed. What if the Fed had to switch from tightening to easing? Markets would puke all over themselves because of how complacent they have gotten with things as is or expect to be.

They are walking a fine line…

With the Fed tightening, volatility seemingly dead, the economy weak, and complacency with a stock market bubble, these are recipes for a market crash.

And as I wrote above, tail events, such as the Fed actually reversing its tightening and switching into easing mode, are not as unlikely as the market thinks.

Just look at the T-bill yield today. US default risk has flatlined for weeks. But now with Trump not being able to get anything done with Congress and the Senate (who’s surprised there), the market is having debt-ceiling anxiety.

The CBO stated that the US Treasury will run out of cash by mid-October.

Ending with that: Although volatility is quiet, it seems like the tails for extreme event probabilities are higher than the crowd complacently assumes.